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Thursday, May 17, 2007

Why I Am Not An Analyst

by Tanta on 5/17/2007 07:19:00 AM

On the way to my Yahoo! mailbox, I caught this headline, "Subprime Shakeout: Where Do We Go From Here?" That demanded to be read.

New Century had a 5-star Morningstar Rating for stocks during its collapse. Why? Good question. Admittedly, the company was risky, hence our above-average risk rating. Indeed, we even recognized that delinquencies would rise. In fact, we had assumptions of increasing charge-offs built into our New Century valuation model. But we underestimated two things.

First, we missed the risk that early payment defaults posed. As we stated, early payment defaults had never been an issue before, and we just did not see that risk on the horizon until it was too late. The risk we saw was loans defaulting as they reset from the "teaser" rate to a fully adjusted rate--the interest rate borrowers will ultimately have to pay after their low teaser rate expires--after two years.

Second, we didn't recognize how quickly the company's financing would disappear. New Century had been a darling of Wall Street, supplying banks with loans to package into new collateralized mortgage obligations. However, once the first problems arose, the very firms that had benefited from the flow of loans were the first to turn off New Century's financing spigot, demanding their money back and effectively killing New Century. The firm was out of cash, could not fund many loans already being processed, and was eventually forced to file for bankruptcy.

Arguably, if New Century had relied upon long-term debt instead of short-term financing, the company would probably still be alive today. No doubt, it would be struggling, as early payment defaults, high delinquency rates, and a reduced number of buyers of subprime mortgages would be taking its toll. But, we believe that with access to cash, New Century might have lived to see another day and maybe even stabilization in the market.
The implication that if New Century had been borrowing operating cash instead of lending capital, it wouldn't have gone bankrupt may not be the funniest thing you read today, but it has its charm. Yes, I'm aware that this is a reductio of the point really being made, which is that if New Century hadn't been using a warehouse line of credit to fund and carry its new held-for-sale loans (borrow short and lend long while you produce enough loans to securitize), and had instead used long-term investors' funds to sell those loans right out of the factory door (borrow long and lend long, really really fast), things would have been different. They surely would have.

What does startle me is the failure to connect the two dots: the EPD problem and the financing problem. My contention is that we have seen unprecedented numbers of EPDs because we were not, actually, lending long, we were pretending to lend long. (This is my Bridge Loan theory about Alt-A and subprime: a loan structure that forces you to refinance in two years or face financial ruin is not a long-term loan, regardless of what the technical final maturity date is).

Traditionally, the "early" in "early payment default" is in reference to a pretty long loan life; the "traditional" average life of a 30-year mortgage just before the boom got underway after 2001 was about 7-10 years, so defaults in the first 90 days were weird and rare. There is, however, something odd about understanding a third-payment delinquency on a 2/28 "exploding ARM" made to a speculator as particularly "early." I mean, how many payments did we expect to take?

Something starts to suggest that we were just borrowing short and lending short, until of course those EPD rates hosed up the liquidity of the loans in the warehouse and we were suddenly borrowing long in real dollars and lending short in Monopoly money. You could see that as an issue of a lack of access to cash, even if like me you think the missing cash is repayments from borrowers rather than loans from investors. In any case I'm still struggling with the idea of how you live to fight another day by soldiering on with a neutral or negative carry. Presumably that would have been solved by the fall-off in loans originated: you can always make it up on lack of volume. So where do we go from here? Those of us who assumed the point was to make money making loans, rather than just make loans, can go back to bed. Everybody else should buy stock.

In other news, I received an email containing some color on current Alt-A and subprime trades, that contained this gem: "Sellers continue to look to product development to figure out ways to originate higher LTV product without subordinate financing."

What this means, for you civilians, is that since we replaced mortgage insurance with borrowed down payments until the down-payment lenders got burnt to a crisp right at the time the MIs decided they wouldn't play with us even if we tied a pork chop around our necks--those things are probably connected--we're back to "product development," which is going to be a bit tricky after that "nontraditional mortgage guidance" thingy told us to quit developing products that fake their way through a lack of borrower equity. But we're willing to try something tricky again, given that the alternative, limiting high LTV loans to people who can afford them, still sucks. What we need is a way for Joe Homebuyer to borrow long and lend short . . .